Business Page – May 5th,
2002

Yet Another Scandal Hits Wall Street (Merill
Lynch)

Introduction

Even
as the Enron saga continues, taking down with it one of the world’s Blue
Chip accounting firms, the centre of American capitalism is faced with yet
another crisis involving securities firms and very specifically prestigious
financial giant Merrill Lynch, one of America’s oldest and largest such
firms. In an action initiated by Eliot Spitzer, Attorney General of New York
under that state’s General Business Law, Merrill Lynch is accused of
serious conflict of interest following an investigation by Spitzer which
found that the firm's supposedly independent and objective investment advice
was tainted and biased by the desire to aid its investment banking business.

Merrill
Lynch is not the only securities firm which is under suspicion or
investigation but it is the one where the investigation is furthest advanced
and which has found it necessary to negotiate with the regulator with a view
to avoiding legal action being taken against it. It has retained the popular
former New York City mayor Rudolph Guiliani (Time’s Man of the Year
2001) to negotiate with Spitzer in what can only be described at this stage
as damage control and which can cost the firm as much as US$2Bn.

Close
to a dozen Wall Street firms including Morgan Stanley and Salomon Smith
Barney have had approaches from the Securities and Exchange Commission
(SEC), according to the prestigious Wall Street Journal.

The
publicity surrounding Enron and its auditors Andersen has caused many in the
investment community to become a little more careful and the financial
statements of once-revered companies like GE and Xerox have come under
intense scrutiny. There is now more than enough evidence that greed drives
the capital market and that for all their high profits and glossy annual
reports, these companies treat their unsuspecting investors as easy prey,
ripe for exploitation by the big players and manipulation by the combined
efforts of those who produce and deliver the financial results. Once again,
it is the size and reputation of the parties involved that is causing the
greatest unease among those in the financial and investment world.

The
Chinese Wall

As
firms increase in size and complexity to meet the one-stop needs of
corporate giant clients across sectors and borders, the range of their
services are forced to expand covering different skills and professions.
Naturally, the potential for overlap increases with the growing likelihood
of what is perhaps euphemistically called conflict of interest. At a securities firm, this tension is usually addressed by the
establishment of a “Chinese Wall” – an internal barrier by which
investment bankers are prevented from sharing with other employees material,
non-public information received by the bankers from their company clients.
In other words, the banker is not allowed to discuss such inside information
with his research analyst counterpart who is providing information to the
public on the same company.

The
Practices

Merrill
Lynch is no small fish struggling for survival although this episode can
have severe consequences for its reputation and pocket. In financial
practices, confidence is everything and that has certainly been eroded.
After all, how can the firm explain the regular practice of deliberately
disseminating misleading information about its corporate clients to help its
banking arm? Or explain why it has practically abandoned its own rating
system which included designating some stocks as “reduce” or “sell”?
Or explain its failure to devise effective policies to address the inherent
conflicts between its investment advice arm and its banking arm?

The
Big Lie

With
the benefit of access to internal communications, Mr. Spitzer was able to
establish that all along some ofMerrill’s
staff were aware that all was not well and had been saying so for some time
within the firm. One of the analysts actually described as not right a
“buy rating to a poor investment” as a result of which “John and Mary
Smith are losing their retirement because we don’t want a client’s CEO
to be mad at us”. And another analyst obviously fed up about pressure from
the investment banking division wrote: "the whole idea that we are
independent of (the) banking (division) is a big lie."

Other
internal communications show analysts privately disparaging companies while
publicly recommending their stocks. For example, one analyst made highly
critical remarks about the management of an internet company and called the
company's stock 'a piece of junk', yet gave the company, which was a major
investment banking client, the firm's highest stock rating."

When
the issue first surfaced Merrill responded with the usual self- righteous
indignation but with the weight of evidence going heavily against it, its
position has shifted to conciliation and contriteness.

Structural
Defects

At
issue is the nature and structure of an industry which drive analysts to
promote companies they do not believe in while their banks earn fees selling
the shares of and offering advice to those very companies. The evidence
suggests that the “Chinese
Wall” is often made of paper which comes down at the whiff of strong fees
or the unfavourable stare of the client CEO. In January last year, an
investor asked a Merrill Lynch analyst why the investment bank had suddenly
started rating the stock of a little-known internet company and pointedly
questioned “what’s so interesting about the company except banking
fees?” The short and honest response: “Nothing.”

It
is interesting to note that the Chinese Wall explanation is often offered by
accounting firms accused of conflicts between their audit and consulting
arms and which were at the centre of the Enron/Andersen affair.

Legal
Action

This
issue could not have come at a worse time for Merrill Lynch. The stock
market has lost billions and some of this would have been borne by those who
followed the firm’s “buy” advice. Merrill Lynch can therefore expect
that in a litigious society as the USA with over-zealous attorneys, legal
action is almost inevitable. One commentator has already suggested that the
threat of criminal action is likely to be the most effective catalyst for
change although Spitzer would like to see institutional regulatory reforms
as well.

Any
lessons for Guyana?

Given
the state of our financial and investment architecturewhich places us light years behind the USA, we may not be in any
danger of this type of practice, certainly on any scale worth noticing. We
are however finally about to launch the Stock Exchange and we do have some
conglomerates which include banking, trust and commercial businesses. At the
moment, the trading in shares that does take place is well outside of the
public eye and appears to lack transparency. Not too long ago we witnessed
an attempt by one company to block its shares being sold to a member of such
a conglomerate.

Some
argue that it is the very practices and mindset of those who control our
public companies which are retarding real progress in the development of a
capital market. Those who own and control our commercial banks whose
operations bear all the hallmarks of cartels may consider the development of
a competitive capital market inimical to their banking interest. We are
painfully aware of the resistance by some of our public companies to provide
shareholders and prospective investors with the quality and flow of
information necessary for the purpose of informed investment decisions.
Meanwhile, those with the responsibility for ensuring that such information
is made available seem unwilling, unable or just too scared of vested
interest to take decisive action.

Conclusion

As
with Enron/Andersen, the case of Merrill Lynch is likely to resonate around
the world and hopefully we in Guyana will take note of the dangers of
conflicts of interest and take appropriate action to prevent them. We
explain our own conflicts by the small size of our population but then
exacerbate the situation by limiting our choice to those with whom we are
“comfortable”. What is even clearer however, is the danger posed by
those determined to manipulate and mislead the public, by greed and the
possibility that dangerous practices are most prevalent in circumstances
where the likelihood of sanction is least. In this regard, we have a fairly
clean slate and we can avoid some of the pitfalls which seem so common in
the more developed countries. Enron, Andersen and now Merrill Lynch are
wonderful examples of how we should not conduct financial and fiduciary
relationships.